It’s a double whammy for mutual fund (MF) investors – as alongside the negative return on most of the equity-oriented funds due to the recent market meltdown, debt fund investors also face a similar fate as policy rates are hiked after being kept low for a few years.

While volatility is the innate characteristic of stock markets, equity investors remain mentally prepared to get the intermittent jolts, it’s a real jolt for debt fund investors, who look for stability in capital invested.

WHAT MAKES RETURNS ON DEBT FUNDS TURN NEGATIVE?

As the returns on debt funds depend on the interest or coupon rates on the underlying debt instruments, risk-averse investors were already getting low returns on the debt funds.

While the higher interest rates would have been good news for the debt fund investors getting lower returns, they suffer a jolt as the market value of the older instruments having lower interest/coupon rates nosedive.

As interest rates have an inverse relation with the prices of existing bonds, debt fund investors should be prepared for more negative return instances soon with more rate hikes.

Moreover, the higher the duration of the debt instruments held by such funds, the more will be the loss and vice versa.

So, retail investors should stick with shorter maturity debt funds as longer-tenure debt funds would be more affected.

Following are the six broad categories of debt funds and the probable impact of rate hikes on them:

OVERNIGHT FUND

Overnight funds invest in securities having maturity of up to 1 day. So, these funds are least affected as the existing securities expire within a day and reinvestments are done on new securities with revised rates every day.

LIQUID FUND

Liquid funds invest in debt and money market securities with maturity of up to 91 days. The effect of rate hike is minimal on these funds as the old securities are replaced by the new securities within 3 months.

ULTRA SHORT DURATION FUND

Ultra short-duration funds invest in debt and money market instruments with Macaulay duration (i.e. the weighted average term to maturity of the cash flows from an instrument) of the portfolio between 3-6 months. So, the suffering of the investors invested in these funds would last for about half a year, until the old instruments are replenished with the instruments having higher interest/coupon rates.

LOW DURATION FUND

Low-duration funds invest in debt and money market instruments with Macaulay duration between 6-12 months. With the pain of holding the instruments having lower interest or coupon rates spanning up to 1 year for such funds, the quantum of loss would be higher than the shorter duration funds.

MONEY MARKET FUND

Money market funds invest in money market instruments having a maturity of up to 1 year. With similar holding periods, the impact of the rate hikes on money market funds would be similar to that of low-duration funds.

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SHORT DURATION FUND

Short-duration funds invest in debt and money market instruments with Macaulay's duration of the portfolio between 1-3 years. For the investors investing in the short duration funds, the duration and the quantum of loss would be the most among the six categories of debt funds as the period of holding of the lower rate instruments spans up to 3 years.

So, while the period of loss for equity fund investors would end with the market uptrend, debt fund investors need to wait till replenishment of the existing lower return instruments with the new ones with higher interest/coupon rates for the end of their agony.